More On The Mysterious (Ongoing) Quant Disruption
If anyone needs indirect evidence of a "mysterious force" that has been forcing the market away from normal behavior for the seventh month in a row now, one simply needs to look at the dramatic continuing underperformance of quant factors, which in turn force quant models to generate false signals and result in major pain for these traditional allocators of capital and market buffers. Quant models, which rely on a statistically "normal" market, are terminally broken, best visualized by YTD drubbing of traditional market natural and L/S indices. But don't take our word for it. For the latest on this ongoing phenomenon, and for what is probably a good representation by proxy of the mysterious permabid phenomenon (call it however you will), we present excerpts from the latest institutional letter by Matt Rothman, head of U.S. Equity Quantitative Strategies at Barclays.
This month’s performance for quantitative factors was unsettling. All three of our Quantitative Themes markedly underperformed. Market Sentiment was down -2.1%. Quality was down -3.1%. And Valuation was down -3.6%. While we have seen bigger monthly moves in these themes in recent years, the fact that all three of these themes underperformed significantly at the same time is noteworthy. Indeed, this simultaneous underperformance of all our themes suggests to us that a disruption may have been (or still is) occurring in this space.
This sobering thought has me searching for the appropriate words and so I find it necessary to turn to my truest and most reliable muse but I am still struggling to find the most appropriate reference. Is it best to paraphrase the opening of Side 1 of Darkness on The Edge of Town – that is the song, Badlands? Or is better to allude to the eerily appropriate last song of the vastly underrated and misunderstood Nebraska album – that is, Reason to Believe? Or still yet, is it the newest Springsteen song which world-premièred Wednesday night at the Meadowlands, where yours truly was privileged enough to be among the lucky people standing inches from the stage as The Boss belted out, for the first time, Wrecking Ball?
But to be clear, we do not want to belittle the seriousness of the situation. This month marks the 5th out of 7 months that our long/short strategy has underperformed. Our trailing 12 month performance number is sobering even if driven primarily by our performance in April 2009. And that a potential disruption in the space could still be so pernicious with quant aum down as much as we estimate it to be over the past 2+ years, well, that is not comforting either.
And while the current situation is very reminiscent of August 2007 in that it generated major underperformance for quants, at least that period managed to rectify in a very short period of time, granted accompanied by a violent swing in the market. The fact that we are now in month 7 of ongoing quant underperformance, without any notable public implosions should raise red flags. One explanation, the one that Zero Hedge has been promoting, is that as traditional L/S and M/N quants have been redeemed and otherwise slighted, other new players have muscled in and taken their spot: most notably incipient market structure monopolists such as Goldman Sachs.
We have searched for prior occasions where we have seen rolling monthly simultaneous underperformance of a similar magnitude. There were few instances of analogous behavior: August 1958; October/November 1974; May/June 1993; May 2001; October, November and December 2001; November 2002; and May/June 2003. Notably, August 2007 was not a comparable period as the model misbehavior was short-lived and self-corrected quickly. In a number of these periods, there was no active quantitative money management community – computers, while invented, were rare and quite expensive in the early periods – and so it is important to recognize that these disruptions can clearly have a variety of sources.
Or one major one...
And probably the most relevant observation from Rothman, highlighting that even as the status quo presumably persists, the likelihood of major shifts behind the scenes becomes greater and greater. Then again, as BGI is in the process of being transferred to BlackRock, the last thing the financial community needs is awareness of major unwinds occurring under everyone's noses.
Equally importantly, we have still not been able to find any direct evidence of an unwind. Based on our conversations with the Barclays Capital trading desks and with numerous clients, we have no direct evidence to support that an unwind has been happening. Like others, we have seen the press reports that a major pension manager was significantly restructuring their allocations to outside managers, particuliarly portable alpha (quantitative?) managers. We would only be speculating to think this was the cause of quantitative model misbehavior into the quarter end. Yet, this hypothesis does not strike us as entirely unreasonable either. We just don’t know. But we sure can observe our model’s behavior which is certainly abnormal.
As Evidence A of "abnormal behavior" and what are likely major ongoing redemptions, be it in portable alpha or otherwise, please see the YTD performance of the HFRX Equity Market Neutral Index: down -6.3% through 9/30. But at least all other pro cyclical indices are performing well, alas not well enough for them to pass their high water mark yet. Just ask New York headhunters how many hedge funds are actually hiring.